Discretionary trusts continue to be a popular structure in Australia for both investment and business purposes. The main reasons for this are asset protection, flexibility to choose ‘who gets what’ each year and the ability to both access and distribute concessions in respect of a disposal of assets.
Unlike a company, a trust usually does not accumulate its profits year on year. While a company may do so and pay tax at 25% or 30% and be able to pass tax credits through to shareholders (franking credits), a trust will pay 45% and not get any credits for doing so. It is for this reason that trusts distribute to beneficiaries each and every year. Individuals who do not earn any other income and are aged 18 and over at 30 June are ideal beneficiaries given the tax-free threshold and subsequent tax thresholds. In the normal course, if there are no ideal individuals to distribute to (or you have run out) a company may be established to receive any remaining distributions.
What is the fuss about?
There is nothing unusual about the above arrangement. Nor is it unusual that those distributions cannot be cash flowed completely. Anyone in business is acutely aware that profit at the end of the year is almost never represented by cash at bank - the reason being that profit is often tied up in working capital, debtors, and other matters required for the business.
Therefore, these ‘entitlements’ to unpaid distributions can build up over time. Those paid to individuals don’t usually have any further tax consequences other than the tax payable by the beneficiary. Others are not quite straight forward such as when they’re made to a company, the distributions need to be either cash flowed or paid to the company over particular time periods. For a long time, this was as hard as it got.
What is the ATO’s concern about unpaid distributions?
In recent times however, the ATO has dusted off an anti-avoidance provision contained in section 100A of the Tax Act that was introduced in 1978 to counter a very specific type of behaviour associated with trusts. That behaviour was usually the introduction of a ‘special purpose beneficiary’ being either another company or trust that had losses or a tax-exempt entity. Once introduced and by agreement, that special purpose beneficiary had a distribution made to it by the trustee. However, it was understood that the distribution would never be called on by the special purpose beneficiary and instead the money would be made available to the controllers of the trust without further taxation.
For section 100A to apply, the following factors must be present:
- a beneficiary who is not under a legal disability to
- have a present entitlement conferred on them (that is a distribution by the trustee)
- with that to happen out of or in connection with a reimbursement agreement
- where someone other than the beneficiary benefits
- and the purpose of the reimbursement agreement or a party to the agreement is the reduction of a tax liability
There is a carve out in section 100A for ordinary family and commercial dealings.
The blatant examples are easy to pick, so why does it impact ordinary users of trusts?
Section 100A looks to capture behaviour where, by agreement (which does not have to be a legally binding agreement, it can just be an understanding or discussion around a dinner table), a beneficiary accepts a distribution from a trustee but there is an understanding that someone or something other than the beneficiary benefits from the distribution.
This is often the case with a common family or discretionary trust. The trustee makes a distribution to a beneficiary, that distribution cannot be cash flowed and is then left ‘as is' with the trustee usually benefiting from that arrangement.
Ordinary family or commercial dealing – the way through for most
Fair to say that most run of the mill situations where the beneficiaries are parents or adult, non-working children who receive distributions but do not call of them are likely to fall in the ordinary dealing carve out. Similarly, one of ‘giftings’ of entitlements amongst family members off the back of estate planning or asset protection objectives are likely to be acceptable as well.
These circumstances all fall within section 100A and would constitute a reimbursement agreement - However, all things being equal however, they should also fall within the ordinary family and commercial dealing carve out.
What if those gifts happen every year? Well, that is likely to be more controversial. That leads us to think about what is acceptable and what is not. Black and white examples are often very difficult to outline but there are certainly some basic principles that you can adhere to when considering ‘who should get what’ and, more importantly, ‘why they should get it’.
Some practical things to do to stay in the clear
The first principle and likely the best one to follow is to not distribute to any beneficiary whom you do not want to actually see the benefit in the long run. You need to think of it in these terms, once you distribute then at some point, you will need to actually pay them. More importantly, once you distribute, they can demand payment of the distribution as it is payable on demand. Quickly you can appreciate why these unpaid entitlements can play havoc in a family law or estate planning context.
The second principle is that it is preferable to pay the distribution out, in cash as soon as practical. Unless you’re good with long term strategy and planning, these unpaid amounts have a sneaky way of building up over time and could cause cash flow problems down the track.
The third and final principle is to not do deals. For a lot of families, the use of a discretionary trust is common as is the parents’ making decisions on who gets what in June and then advising adult children the next financial year or calendar year so they can ensure they lodge their tax returns appropriately. Done this way, there is no agreement to allow the avoidance provision to operate.
It may also be the case that as part of June planning, adult children are party to the decision making process and are made aware of the likelihood of distributions. There may also be an understanding that they will not call on those distributions because, for example, they also work in the business operated by the trust and understand the needs of the business and know that they will benefit in the long term on a potential future sale.
At that point in time, you do have an agreement and while it will enliven the avoidance provision you would expect this fact pattern to fall within the ordinary family or commercial dealing carve out.
So, what to do about trusts and distributions? Make sure you pay them and, if not, make sure you don’t make any deals you’ll come to regret.
Some of you may want a deeper dive into the issue so it would be recommended that that you have a look at the ATO’s Practical Compliance Guideline PCG2022/2 here for some practical examples of what is ok and what is not as well as Taxation Ruling TR2022/4 for a deep dive into the technical issues here.
